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Basics of Dow Theory

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  • Basics of Dow Theory

    Smart traders read the secrets of the chart

    The legendary Charles Dow and successful traders like Jesse Livermore knew how to read the markets by observing the behavior of its participants. You too can learn how they did it.

    Reading the “secret” of the charts isn’t much of a secret at all. In fact, Charles Dow wrote it all down in his Dow Theory on stock price movements, it’s main point being that markets run in trends and that it’s a good idea to follow those trends. Though this may sound simple, it isn’t that easy to do as it brings up some very tricky questions. What would be the optimal point in a market movement to open a position; and why? And considering other traders’ reactions, which points in a trending market hold the most favorable profit potential?

    Before we address these questions, let’s step back and cover Dow’s basic theory of trends.

    Take a look at image 1.

    Image 1: In the top section, an illustration of an uptrend, the red circle identifies the continuance of an existing trend. The continuing progressions and regressions with increasing highs (2) and lows (3) keep the trend running. The section below illustrates the same situation, but for a downtrend with decreasing lows (2) and highs (3).
    • An uptrend exists if you can see a sequence of higher highs (P2) and higher lows (P3).
    • Respectively, downtrend exists if there is a sequence of lower lows (P2) and lower highs (P3).

    A trend consists of two main parts: movements and corrections:
    • Movements go in the direction of the trend.
    • Corrections go in the opposite direction of the trend.

    And the end of a trend occurs when its most recent P3 gets violated by a counter movement.

    There are plenty of software applications that accurately identify strong trending movements and their corrections. But they often fail when it comes to skillful trade execution. Empirical studies have shown that the overall hit rate for a large majority of trend following software hovers around 50%, its poor trade management capabilities unable to produce sustainable long-term profits.

    Given these stats, what can you do to noticeably improve your personal hit rate when it comes to trading trends? Cranking up the frequency of trades might not be a good solution. After all you want quality trades, not just a larger quantity of trades.

    What if you were able to accurately identify on the chart the high-probability areas where other traders might want to buy your position at an even higher price? What if you can identify whether there are even other traders in the market willing to take your trades? To trade successfully, you always have to keep in mind other market participants: who is willing to buy your current long position, and who is willing to sell your current short position.

    Fortunately, by viewing a chart in the way Charles Dow did, you can read beyond the prices to get to the actual “intentions” of other traders in the market.

    How to trade trends

    To trade trends successfully, you must first understand how a trend functions–namely, what generates it and how market participants play a role in shaping it.

    For instance, an uptrend for a stock begins when demand is greater than the current supply. Buyers are willing to pay higher prices to own it. This causes a stock’s price to rise as continuous bidding takes place at higher price levels.

    Picture 2 illustrates this process, in which the formation of an uptrend takes place in three distinct price runs.
    1. A period of increasing prices followed by…
    2. A period of decreasing prices, followed again by…
    3. A period of increasing prices.

    Image 2: The letters UT in the upper part of the graphic illustrate the point of the trend formation. The initial movements 1, 2 and 3 in the grey boxes stand for the prior uptrend forming phases. The boxes R and P represent the trend components regression and progression. Below you see the same situation but for a downtrend (DT).

    In the top image where it says UT (for Uptrend), notice the price movements designated R for regression and P for progression. When the progression (P) exceeds the regression (R) segment you have confirmation of a trend. You can then open a new long position. In the future, you can expect a rotation of these two–R and P–components.

    Progression and regression

    You will notice that within R and P are sub-trends (or what some call micro-trends). These sub-trends are easier to see in smaller timeframes. However, if you are interested in trading a breakout of the correction (the regression period) or simply trading the major progression, you will want to watch out for the moment where the major trend continues breaks out of its corrective/regressive period.

    Intentions of other market participants

    Once you can clearly identify the trend formation, it is now time to consider the intentions of the other market participants who play a role in shaping the outcome of this trend.
    1. Trend-trader. They trade a trend from the beginning until the end. They open a (first) position with the initial formation of the trend. Further on you will likely find their orders for additional positions, pyramiding at every P2. The active stop can be anticipated at the current P3.
    2. Progression-trader. They trade into the direction of the primary trend and open a position when the correction has finished. Their goal is it to trade the progression of the primary trend.
    3. Regression-trader. They trade the counter direction of the primary trend and open a position if the progression trend got broken by a countertrend.

    All three types of traders trade according to the same trend formation principles. The difference between them happens to be a) their point of entry,and in the case of regression traders, b) trend direction.

    Unveil the secrets of the chart

    To find a profitable trade you will need an advantage in the market. And knowing who will buy and sell your position and at what points they will buy and sell can be a tremendous advantage. All of the traders involved leave traces with their orders on a chart. Understanding other traders’ intention can help you plan your trade accordingly. The traces left by other traders will help you figure out the critical points in a chart, knowledge which can help unveil their plans to your advantage. All you have to do is put the informational pieces together and identify the highest-probability opportunities.

    Please register to our free Webinar on September 12, 2017 to learn more about the secrets of Dow Theory.

  • #2
    Why Wall Street traders are obsessed with Jesse Livermore

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    Born in 1877, Jesse Livermore is one of the greatest traders that few people know about. While a book on his life written by Edwin Lefèvre, "Reminiscences of a Stock Operator" (1923), is highly regarded as a must-read for all traders, it deserves more than a passing recommendation. Livermore, who is the author of "How to Trade in Stocks"(1940), was one of the greatest traders of all time. At his peak in 1929, Jesse Livermore was worth $100 million, which in today's dollars roughly equates to $1.5-13 billion, depending on the index used.

    The enormity of his success becomes even more staggering when considering that he traded on his own, using his own funds, his own system, and not trading anyone else's capital in conjunction. There is no question that times have changed since Mr. Livermore traded stocks and commodities. Markets were thinly traded, compared to today, and the moves volatile. Jesse speaks of sliding major stocks multiple points with the purchase or sale of 1,000 shares. And yet, despite the difference in the markets, such automation increased liquidity, technology, regulation and a host of other factors that still drive the markets today.

    The Test of Time
    Given that this trader's rules still apply, and the price patterns he looked for are still very relevant today, we will look at a summary of the patterns Jesse traded, as well his timing indicators and trading rules. (For more classic and lesser-known investing titles to add to your collection, check out Investing Books It Pays To Read.)

    Price Patterns
    Jesse did not have the convenience of modern-day charts to graph his price patterns. Instead, the patterns were simply prices that he kept track of in a ledger. He only liked trading in stocks that were moving in a trend, and avoided ranging markets. When prices approached a pivotal point, he waited to see how they reacted.

    For instance, if a stock made a $50 low, bounced up to $60 and was now heading back down to $50, Jesse's rules stipulated waiting until the pivotal point was in play in order to trade. If that same stock moved to $48, he would enter a trade on the short side. If it bounced up off the $50 level, he would enter long at $52, closely watching the $60 level, which is also a "pivotal point." A rise above $60 would trigger an addition to the position (pyramiding) at $63, for example. Failure to penetrate or hold above $60 would result in a liquidation of the long positions. The $2 buffer on the breakout in this example is not exact; the buffer will differ based on stock price and volatility. We want a buffer between actual breakout and entry that allows us to get into the move early, but will result in fewer false breakouts.

    While Jesse did not trade ranges, he did trade breakouts from ranging markets. He used a similar strategy as above, entering on a new high or low but using a buffer to reduce the likelihood of false breakouts. (Find more profitable entry and exit locations with this standard indicator; read Measure Volatility With Average True Range.)

    Price patterns, combined with volume analysis, were also used to determine if the trade would be kept open. Some of the criteria Jesse used to determine if he was in the right position were:
    • Increased volume on breakout.
    • The first few days after the break prices should move in the breakout direction
    • A normal reaction occurs where prices retrace somewhat against the trend, but volume is lower on retracements than it was in the trending direction.
    • As the normal reaction ends, volume increases once again in the direction of the trend.

    Deviations from these patterns were warning signals and, if confirmed by price movements back through pivotal points, indicated that exited or unrealized profits should be taken. (For more read our Greatest Investors Tutorial.)

    Timing the Market
    Any trader knows that being right a little too early or a little too late can be as detrimental as simply being wrong. Timing is crucial in the financial markets, and nothing provides better timing than price itself. The pivotal points mentioned above occur in individual stocks and market indexes, as well. Let price confirm the trade before entering large positions.

    Jesse Livermore believed no matter how much we "feel" that we know what is happening, we need to wait for the market to confirm our thesis. And only when it does do we make our trades - and we must do so promptly. (From picking the right type of stock to setting stop-losses, learn how to trade wisely in Day Trading Strategies For Beginners.)

    Trading Rules
    The trading rules that follow are simple, and have been included in many trading plans by many traders since they were created nearly a century ago. They are still valid today, and were created under Jesse's truism: "There is nothing new in Wall Street. There can't be, because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again."
    • Trade with the trend. Buy in a bull market, short in a bear market.
    • Don't trade when there aren't clear opportunities.
    • Trade using the pivotal points. (Learn how to spot the pivot point from which a new movement will emerge; read Find A Trend With The Partial Retrace.)
    • Wait for the market to confirm opinion before entering. Patience leads to "the big money."
    • Let profits run. Close trades that show a loss (good trades generally show profit right away).
    • Trade with a stop, and know it before you enter.
    • Exit trades where the prospect of further profits is remote (trend is over or waning).
    • Trade the leading stocks in each sector; trade the strongest stocks in a bull market, or the weakest stocks in a bear market.
    • Don't average down a losing position.
    • Don't meet a margin call; close the position instead.
    • Don't follow too many stocks.

    Summing Up Jesse Livermore's Strategy
    Jesse was highly successful, but also lost his fortune several times. He was always the first to admit when he made a mistake, and when he lost money it came down to two potential culprits:
    1. The rules for trading were not fully formulated (not the case for most of his losses).
    2. The rules were not followed.

    For today's trader, these are still likely the culprits that keep profits at bay. To be profitable, we must actually create a profitable trading system, and then we must adhere to it in actual trading.
    Jesse outlined a simple trading system for us: wait for pivotal points before entering a trade. When the points come into play, trade them using a buffer, trading in the direction of the overall market. Let the price dictate our actions and stay with profitable trades, until there is good reason to exit the trade. Losses should be small and trading should be avoided when there are no clear opportunities. When there are trading opportunities, trade stocks that are most likely to move the most. (For more books, check out Ten Books Every Investor Should Read.)

    Read more: Jesse Livermore: Lessons From A Legendary Trader
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    • #3
      Find High-Probability Trades with Trend Combinations

      When you look at a chart you can often see different trends flowing into each other. A clever combination of these trends will provide clear insights into trading opportunities, as if the market itself came knocking upon your door. You just need the patience to wait for the right moment, like a hunter waiting for the right moment to shoot his prey.

      How to see the right moment

      If you can discern the intentions of the other trend trading actors you can read the marks they left on the chart. You get a pretty clear picture of price marks where for example:
      • Trends continue or break and trend traders become active
      • Where a progression finishes and regression traders start opening positions
      • When the regression ends and trend traders once again place orders

      Combination of trends

      The existence of a multiple-trend chart depends on the market liquidity. Basically, you can assume that highly liquid assets create more different trends than assets with lower liquidity. The higher the liquidity the larger the presence of different trends appearing in charts of the selected timeframe. Usually there are up to four trend sizes to see:
      • Large trend
      • Medium trend
      • Small trend
      • Smallest trend

      Pay attention to the combination of the different trend sizes. Practice has been proven that you can trade the individual parts of a trend, namely its progression and regression. Furthermore, practice has shown that you can trade out of a trend’s correction by using the following combinations:
      • Large trend vs. medium trend
      • Medium trend vs. small trend
      • Small trend vs. smallest trend

      The larger trend is always superior and therefore provides direction. You use the minor trend to trade into the superior.

      There is one thing in the context of trend combination that you should absolutely consider: A signal resulting from two converging trends work respectably when two direct continuous trends are in combination.

      Failed trades are often based on a misinterpretation of different visible trend-sizes.

      Here is an example:

      You use the medium trend to set your superior trading direction. Within it you can view the progression and regression arms created by the small trend.

      When the small regression trend is broken and a new progression trend has formed, the cards are good for the start of a new movement toward the superior trend.

      But if you use the “smallest” trend in combination with the medium you will jump the small (minor) trend. If the minor trend is still running against the superior trend and you trade the smallest trend into the medium, you end up catching a falling knife.

      If you are looking for low-risk trades using trend combinations, never trade against the superior trend. That will only boost your risk and increase the chances for a missed trade.

      Setup for new trends – trend break by a movement

      An existing trend is violated by a price movement that is more or less trendless. After the trend break, wait for a counter movement followed by a third movement into the direction of the original trend. At the price level where the new trend will be formed can you open your first position. Work with a Stop-(Limit*)-Order to make sure that you open your position only if the trend is existent.

      *Use the additional price limit to make sure that you pay not more (long) or get not less (short) as you want for your position opening.

      For the case that the prior trend break happened trough an existing trend, use the following setup for trading an existing trend out of the correction.

      Image 1:

      At the left hand side do you see an uptrend (UT) followed by a regression(R). The regressive price movements formed what appears as a counter trend–a sub-trend with its own smaller movements and regressions. In the red box, you will notice that the downward trend establishes a set-up(PO): a price level that, if violated, confirms a short trade.

      The right-hand side of this picture display the actual violation of this (UT) price level. The position opening (PO) occurs in that case with the formation of the new trend after a counter movement (CM) in the red box.

      Entry into a running trend – trend break by a countertrend

      Here we find an already existing trend. As a trend trader you can decide to trade the trend or just its progression component (also called movement). No matter what you trade, the entry strategy is the same for both. But there will be differences in setting the stop-loss and take-profit levels.

      To enter a running trend, you are looking for a scenario in which the regression trend (a correction) has ended, such as in the case of a breakout. This is similar to finding a “new” trend within the larger movement. In other words, you simply trade the minor trend.

      Primary position protection and stop trailing

      To find the right protection level for your trade you should determine where the existing trend will get broken. You should identify the price level at which the trend will no longer be valid, hence marking the end of the trade. In short, a trend ends with a violation of the current P3.

      So when you trade the superior trend, look for P3 level. If you are trading the minor trend, watch out for the minor P3 level area. The P3 area is where you will want to set your initial stop-loss.

      If you are using a trailing stop, keep it simple by placing your stop at the correction lows in an uptrend and correction highs in a downtrend.

      Always protect your trade with a stop-loss (which is, of course, a “stop” order).

      Setting a target

      When you trade the superior trend (that is, the longer primary trend), you will be working without a profit target. The reason for this is that you will not know beforehand where that final target will be. The same can be said if you are trading a minor that is in the same direction of the superior trend.

      But if you are trading out of a deep correction, and if these is enough money to be earned in that trade, then you can set a profit target near the P2 of the superior trend.

      Be sure to use Limit Orders for all your take-profit targets.

      Trading a trend in combination with minor trends has a huge advantage. You find all the important information in one chart. And this helps you focus on profitable pivot situations within existing trends. You will not need additional indicators. By viewing the basic price action, you will be able to identify profit opportunities directly from the chart.

      Please register to our free Webinar to learn about the Dow Theory in more detail.


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